A Brief Commentary on the State of the Asset Bubble

Since I am commenting on bubbles, let me share with you a few observations I have made after doing a little research on this phenom known as Interest Only mortgages. As you may have picked up from our various conversations over the last year, I have concluded that the cause of the run up in real estate values has been not just the reduction in rates, but more importantly the new loan structures that have been popping up . The most prevalent of these have been the Interest Only loans. In places like CA and FL, and other major markets, these loans are easily 50% of the volume in the last 6-12 months. Also increasing have been what are called Stated Income mortgages (where the borrower does not need to document his income); we also have another name for these mortgages - Liar Loans.

Anyway, let's look at the numbers, shall we ? (as I have also said over the years, based on my vast level of commercial banking experience, "Numbers don't lie - people do!") As of this past Spring, the payment on a 3-yr ARM I/O was approximately 51% of a what the payment would have been on a 30-yr fixed fully amortizing mortgage (3.5% rate on the 3-yr ARM I/O vs. 5.5% rate on the 30-yr fixed); and the I/O payment was 65% of a similar rate amortizing 3-yr ARM. It gets scarier. In three years when the I/O begins to amortize (over the remaining 27 yrs. rather than 30 yrs.), assuming that the rate bumps up to its cap of 2% over the start rate, the rate is now 5.5% and the payment is double what it had been. Assuming that these borrowers qualified for these loans with what we call a front-end ratio of about 28-30% (to be fair, the numerator in this fraction includes not only P&I, but also taxes and insurance, which will probably not double in cost but can certainly rise), then this doubling of the payment will now mean that the new payment is between 50 and 60% of the borrower's gross income. Ouch! That's gotta hurt! Interestingly, the MI companies have not been charging any additional premium for I/O loans versus amortizing loans. To paraphrase a song title from the great and late grunge rocker Kurt C, "smells like a shorting opportunity." As an offset to massive defaults, the other trend it may portend, is another refi boom beginning in a couple years as the I/O's start amortizing. Think about it.

Let me move on to something a little more light-hearted (since I also promised when I started this blog some current events and culture). I saw the movie "Dodgeball" a couple days ago and it was great. I really need to take a notebook with me if I am going to comment on these movies since I seem to have the memory of RR in his golden years, but basically, you all know the plot, right? Group of lovable losers needs to play a rival group of steroid induced, Teutonic specimens to save their lowly gym from certain destruction by a demonic psychopath (sort of like "The Country Bears" without the great music and dance numbers). Anyway, the promos mention Ben stiller and V. Vaughan, and they are pretty good, but movie is made by a couple other characters, including Jason Batemen, and Rip Torn (even Lance Armstrong has a great cameo).